Chapter 4: What's Wrong with the
World, Part 2

"Where two carriages come in collision, if there is no
negligence in either it is as much the act of the one driver as of the
other that they meet."

Bramwell, B. in Fletcher v.
Rylands, 3 H. & C. 774 (Ex. 1865)

The argument of the previous chapter can be stated
quite simply:

A takes an action that imposes a cost upon
B. In order to make A take the action if and only if it produces net
benefits, we must somehow transfer the external cost back to him. The
polluting company is charged for its pollution, the careless motorist
is sued for the damage done when he runs into someone else's car. The
externality is internalized, the actor takes account of all relevant
costs in deciding what action to take, and the result is an efficient
pattern of decisions.

That view of externalities, originally due to
Pigou, was almost universally accepted by economists until one
evening in 1960, when a British economist named Ronald Coase came to
the University of Chicago to deliver a paper. He spent the evening at
the house of Aaron Director, the founding editor of the Journal of
Law and Economics. Counting Coase, fourteen economists were present,
three of them future Nobel Prize winners.

When the evening started, thirteen of them
supported the conventional view of externalities described above.
When the evening ended, none of them did. Coase had persuaded them
that Pigou's analysis was wrong, not in one way but in three. The
existence of externalities does not necessarily lead to an
inefficient result. Pigouvian taxes do not in general lead to the
efficient result. Third, and most important, the problem is not
really externalities at all. It is transaction costs.

I like to present Coase's argument in three steps:
Nothing Works, Everything Works, It All Depends (on transaction
costs).

Nothing
Works

An external cost is not simply a cost produced by
one person and borne by another. In almost all cases, the existence
and size of external costs depend on decisions by both parties. I
would not be coughing if your steel mill were not pouring out sulfur
dioxide. But your steel mill would do no damage to me if I did not
happen to live downwind from it. It is the joint decision, yours to
pollute and mine to live where you are polluting, that produces the
cost. If you are not liable to me for the damage done by your
pollution, your decision to pollute imposes a cost on me. If you are
liable, my decision to live downwind imposes a cost, in liability or
pollution control, on you.

Suppose pollution from a steel mill does $200,000
a year worth of damage and could be eliminated at a cost of $100,000
a year (from here on, all costs are per year). Further assume that
the cost of shifting all of the land downwind to a new use unaffected
by the pollution, timber instead of summer resorts, is only $50,000.
If we impose an emission fee of $200,000 a year, the steel mill stops
polluting and the damage is eliminated at a cost of $100,000. If we
impose no emission fee, the mill keeps polluting, the owners of the
land stop advertising for summer visitors and plant trees instead,
and the problem is again solved, this time at a cost of $50,000. The
result without Pigouvian taxes is efficient—the problem is
eliminated at the lowest possible cost—and the result with
Pigouvian taxes is inefficient.

Even draconian limits on emissions in southern
California would be less expensive than evacuating that end of the
state; indeed, it is unlikely that moving the victims is often an
efficient solution to the problems of air pollution. But consider the
same logic applied to the externalities produced by testing high
explosives. A thousand-pound bomb produces substantial external
effects if it lands fifty feet from your campsite. Keeping campers
out of bomb ranges seems a more sensible solution than letting them
in and permitting them to sue for the resulting damage.

For a less exotic example consider airport noise.
One solution is to reduce the noise. Another is to soundproof the
houses. A third is to use the land near airports for wheat fields or
noisy factories instead of housing. There is no particular reason to
think that one of those solutions is always best. Nor is it entirely
clear whether the victim is the landowner who finds it difficult to
sleep in his new house with jets going by overhead or the airline
forced by a court or a regulatory agency to adopt expensive sound
control measures in order to protect the sleep of people who chose to
build their new houses in what used to be wheat fields, directly
under the airport's flight path.

Finally, consider an example in which the
sympathies of most of us would be with the "polluter." The owner of
one of two adjoining tracts of land has a factory that he has been
running for twenty years with no complaints from his neighbors. The
purchaser of the other tract builds a recording studio on the side of
his property immediately adjacent to the factory. The factory, while
not especially noisy, is too noisy for something located two feet
from the wall of a recording studio. The owner of the studio demands
that the factory shut down or else pay damages equal to the full
value of the studio. There are indeed external costs associated with
operating a factory next to a recording studio. But the efficient
solution is building the studio at the other end of the lot, not
building the studio next to the factory and then closing down the
factory.

So Coase's first point is that since external
costs are jointly produced by polluter and victim, a legal rule that
assigns blame to one of the parties gives the right result only if
that party happens to be the one who can avoid the problem at the
lower cost. In general, nothing works. Whichever party the blame is
assigned to, by government regulators or by the courts, the result
will be inefficient if the other party could prevent the problem at a
lower cost or if the optimal solution requires precautions by both
parties.

One advantage of effluent fees over direct
regulation is that the regulator does not have to know the cost of
pollution control in order to produce the efficient outcome; he just
sets the tax equal to damage done and lets the polluter decide how
much pollution to buy at that price. But one implication of Coase's
argument is that the regulator can guarantee the efficient outcome
only if he knows enough about the cost of control to decide which
party should be considered responsible for preventing the jointly
produced problem, and so required to bear the cost if it is not
prevented.

Everything
Works

The second step in Coase's argument is to observe
that, as long as the parties can readily make and enforce contracts
in their mutual interest, neither direct regulation nor a Pigouvian
tax is necessary in order to get the efficient outcome. All you need
is a clear definition of who has a right to do what and the market
will take care of the problem.

Our earlier case of the steel mill and the resorts
showed one way of getting to the efficient result without legal
restrictions on pollution. The lowest-cost avoiders were the owners
of the land downwind; since they could not prevent the pollution they
shifted from operating resorts to growing timber, which happened to
be the efficient outcome.

What if, instead, the legal rule had been that the
people downwind had a right not to have their air polluted? The final
result would have been the same. The mill could eliminate the
pollution at a cost of $100,000 a year. But it is cheaper to pay the
landowners some amount, say $75,000 a year, for permission to
pollute. The landowners will be better off, since what they are
getting is more than the cost to them of changing the use of the
land. The steel mill will be better off, since what it is paying is
less than the cost of eliminating the pollution. So it pays both
parties to make such an agreement.

Next suppose we change our assumptions, lowering
the cost of pollution control to $20,000. If the mill has the right
to pollute, the landowners will pay more than the $20,000 cost of
pollution control in exchange for a guarantee of clean air. If it
does not have the right to pollute, the most the steel mill will be
willing to offer the landowners for permission to pollute is $20,000,
and the landowners will turn down that offer. Either way, the mill
ends up controlling its pollution, which is now the efficient
solution.

The generalization of this example is
straightforward:

If transaction costs are zero, if, in other
words, any agreement that is in the mutual benefit of the parties
concerned gets made, then any initial definition of property rights
leads to an efficient outcome.

This result is sometimes referred to as the
Coase Theorem.

We have just restated the simple argument for
laissez-faire in a more sophisticated form. What people own are not
things but rights with regard to things. Ownership of a steel mill is
a bundle of rights: the right to control who comes onto the property,
the right to decide how the machinery is used, ... . It may or may
not also include the right to produce pollution. If that right is
more valuable to the owner of the bundle of rights we call "ownership
of the steel mill" than to anyone else, he will keep it if he owns it
and buy it if he does not. If it is more valuable to property owners
downwind, they will keep it if they own it and buy it if they do not.
All rights move to those to whom they are of greatest value, giving
us an efficient outcome.

It All Depends
(On Transaction Costs)

Why, if Coase is correct, do we still have
pollution in Los Angeles? One possible answer is that the pollution
is efficient, that the damage it does is less than the cost of
preventing it. A more plausible answer is that much of the pollution
is inefficient, but that the transactions necessary to eliminate it
are blocked by prohibitively high transaction costs.

Let us return again to the steel mill. Suppose it
has the right to pollute but that doing so is inefficient; pollution
control is cheaper than either putting up with the pollution or
changing the use of the land downwind. Further suppose that there are
a hundred landowners downwind.

With only one landowner there would be no problem;
he would offer to pay the mill for the cost of the pollution control
equipment plus a little extra to sweeten the deal. But a hundred
landowners face what economists call a public good problem. If
ninety of them put up the money and ten do not, the ten get a free
ride—no pollution and no cost for pollution control. Each
landowner has an incentive to refuse to pay, figuring that his
payment is unlikely to make the difference between success and
failure in the attempt to raise enough money to persuade the steel
mill to eliminate its pollution. If the attempt is going to fail even
with him, it makes no difference whether or not he contributes. If it
is going to succeed even without him, then refusing to contribute
gives him a free ride. Only if his contribution makes the difference
does he gain by agreeing to contribute.

There are ways in which such problems may
sometimes be solved, but none that can always be expected to work.
The problem becomes harder the larger the number of people involved.
With many millions of people living in southern California, it is
hard to imagine any plausible way in which they could voluntarily
raise the money to pay all polluters to reduce their
pollution.

This is one example of the problem of transaction
costs. Another occurs if we reverse our assumptions, making pollution
(and timber) the efficient outcome but giving landowners the legal
right to be pollution free. If there were one landowner the steel
mill could buy from him the right to pollute. With a hundred, the
mill must buy permission from all of them. Each has an incentive to
be a holdout, to refuse his permission in the hope of getting paid
off with a large part of the money the mill will save from not having
to control its pollution. If too many landowners try that approach,
the negotiations break down and the parties never get to the
efficient outcome.

Seen from this perspective, the problem is not
externalities but transaction costs. With externalities but no
transaction costs there would be no problem, since the parties would
always bargain to the efficient solution. When we observe externality
problems (or other forms of market failure) in the real world, we
should ask not merely where the problem comes from but what the
transaction costs are that prevent it from being bargained out of
existence.

Coase plus
Pigou Is Too Much of a Good Thing

There is one more use for our polluting factory
before we move on to more pastoral topics. This time we have only one
factory and one landowner, so bargaining between them is simple.
Pollution does $60,000 worth of damage, pollution control costs
$80,000, switching the land use from resorts to timber costs
$100,000. The efficient outcome is pollution, since the damage done
is less than the cost of avoiding it.

The EPA, having been persuaded of the virtues of
Pigouvian taxes, informs the factory that if it pollutes, it must pay
for the damage it does—a $60,000 fine. What
happens?

Controlling the pollution costs more than the
fine, so one might expect the factory to pay the fine and continue to
pollute, which is the efficient solution. That is the obvious answer,
but it is wrong.

We have forgotten the landowner. The fine goes to
the EPA, not to him, so if the factory pays and pollutes, he suffers
$60,000 of uncompensated damage. He can eliminate that damage by
offering to pay part of the cost of pollution control, say $30,000.
Now, when the factory controls its pollution, it saves a $60,000 fine
and receives a $30,000 side payment from the landowner, for a total
of $90,000, which is more than the $80,000 cost of pollution control.
The result is pollution control that costs more than it is
worth.

We are adding together Pigou's incentive (a fine
for polluting) and Coase's incentive (a side payment from the victim
for not polluting), giving the factory twice the proper incentive to
control its pollution. If the cost of control is less than twice the
benefit, the factory buys it even if it shouldn't.

One solution is to replace administrative law with
tort law, converting the fine paid to the EPA into a damage payment
to the landowner. Now he is compensated for the damage, so he has no
incentive to pay the factory to stop polluting.

Coase, Meade,
and Bees

Ever since Coase published "The Problem of Social
Cost," economists unconvinced by his analysis have argued that the
Coase Theorem is merely a theoretical curiosity, of
little or no practical importance in a world where transaction costs
are rarely zero. One famous counterexample concerns bees.

Writing before Coase, James Meade (who later
received a Nobel Prize for his work on the economics
of international trade) offered externalities associated with
honeybees as an example of the sort of problem for which the market
offered no practical solution. Bees graze on the flowers of various
crops, so a farmer who grows crops that produce nectar benefits the
beekeepers in the area. The farmer receives none of the benefit
himself, so he has an inefficiently low incentive to grow such
crops.

Since bees cannot be convinced to respect property
rights or keep contracts, there would seem to be no practical way to
apply Coase's approach to the problem. We must either subsidize
farmers who grow nectar-rich crops (a negative Pigouvian tax) or
accept inefficiency in the joint production of crops and
honey.

It turns out that it isn't true. As supporters of
Coase have demonstrated, contracts between beekeepers and farmers
have been common practice in the industry at least since early in
this century. When the crops were producing nectar and did not need
pollination, beekeepers paid farmers for permission to put their
hives in the farmers' fields. When the crops were producing little
nectar but needed pollination (which increases yields), farmers paid
beekeepers. Bees may not respect property rights but they are, like
people, lazy, and prefer to forage as close to the hive as
possible.

That a Coasian approach solves that particular
externality problem does not imply that it will solve all such
problems. But the observation that an economist as distinguished as
Meade assumed an externality problem was insoluble save by government
intervention in a context where Coase's market solution was actually
standard practice suggests that the range of problems to which the
Coasian solution is relevant may be much greater than many would at
first guess. And whether or not externality problems can be bargained
away, Coase's analysis points out fundamental mistakes in the
traditional way of thinking about externalities: the failure to
recognize the symmetry between "polluter" and "victim" and the
failure to allow for private approaches to solving such
problems.

A different way of putting the point is to observe
that the Pigouvian analysis of the problem is correct, but only under
special circumstances, situations in which transaction costs are
high, so that transactions between the parties can safely be ignored,
and in which the agent deciding which party is to be held liable
already knows who the lowest-cost avoider of the problem is. Air
pollution in an urban area is an obvious example. Coase provides the
more general analysis, covering both that case and all
others.

Considered from the standpoint of a court there
are at least two different ways in which these insights might be
applied. Courts could follow a policy of deciding, in each case,
whether plaintiff or defendant was the lowest-cost avoider, awarding
damages for pollution only if it concluded that the polluter could
solve the problem more cheaply than the victim. Alternatively, courts
could try to establish general rules for assigning liability,
rules that usually assigned liability to the party that was usually
the lower cost avoider.

One example of such a general rule is the tort
defense of "coming to the nuisance." Under this doctrine, if
you build your housing development next to my pig farm, I may be able
to avoid liability by arguing that, because I was there first, you
were the one responsible for the problem. An economic justification
for the doctrine is that it is less expensive to change the location
of a development, or a pig farm, before it is built than after,
making the second mover usually the lower-cost avoider of the
problem. We will return to this example, along with some
complications, in later chapters.

General rules have several advantages over
case-by-case decisions. They are usually more predictable, making it
possible for parties to take decisions without having to guess who
some future court will think was the lowest-cost avoider of future
problems. They reduce litigation costs, since using expensive legal
resources to convince a court that the other party can solve the
problem more cheaply than you can is more likely to work than using
similar resources to convince a court that your housing development
was built ten years earlier than it really was. The disadvantage of a
general rule is that it can be expected to give the wrong answer in
some specific cases, which means that a general rule will do a worse
job of guaranteeing efficient outcomes than would a perfectly wise
court deciding each case on its individual merits.

General rules that yield easily predictable
results are sometimes referred to as bright line rules; rules
that require a case-by-case decision by courts are sometimes referred
to as standards. Consider, as one example, the requirement in
the United States Constitution that a candidate for president must be
at least thirty-five years old. Presumably the purpose is to ensure
that candidates be sufficiently mature for the job. It is a bright
line rule, but not a very good one, since chronological age is only a
very rough measure of maturity; all of us can think of examples of
people over thirty-five who are less mature than many people under
thirty-five. Some of us may even be able to think of ones who have
been elected president.

But consider the alternative—a standard
specifying that a candidate for president must be as mature as the
average thirty-five-year-old. That is a very fuzzy rule
indeed—one that reduces, in practice, to the requirement that
any candidate must be acceptable to a majority of the justices on the
Supreme Court.

A still more important example of a bright line
rule is the general principle that all human beings, with some narrow
exceptions for children and lunatics, have the same legal
rights—very different from the legal rights of animals. The
features of human beings that give rise to legal rights are not
all-or-none matters; most humans are more rational and better able to
communicate than most animals, but again many of us can think of
exceptions. A perfect legal system with perfectly wise judges would
presumably enforce legal rights that varied from person to person
(and animal to animal), tracking the variation in the features that
gave rise to those rights. The result might well be that a
sufficiently retarded human being would have fewer rights than a very
smart chimpanzee.

Our legal system does not work that way and
probably shouldn't. The human/not human distinction is not a perfect
measure of intelligence, linguistic ability, and the like, but it is
a very good one—and it generates a bright line rule that
avoids most of the problems of some humans trying to persuade courts
that they have different rights than others.

Coase,
Property, and the Economic Analysis of Law

Coase's work radically altered the economic
analysis of externalities. It also suggested a new and interesting
approach to the problem of defining property rights, especially
property rights in land.

A court settling disputes involving property, or a
legislature writing a law code to be applied to such disputes, must
decide which of the rights associated with land are included in the
bundle we call "ownership." Does the owner have the right to prohibit
airplanes from crossing his land a mile up? How about a hundred feet?
How about people extracting oil from a mile under the land? What
rights does he have against neighbors whose use of their land
interferes with his use of his? If he builds his recording studio
next to his neighbor's factory, who is at fault? If he has a right to
silence in his recording studio, does that mean that he can forbid
the factory from operating or only that he can sue to be reimbursed
for his losses? It is simple to say that we should have private
property in land, but ownership of land is not a simple
thing.

The Coasian answer is that the law should define
property in a way that minimizes costs associated with the sorts of
incompatible uses we have been discussing: airports and residential
housing, steel mills and resorts. The first step is to try to define
rights in such a way that, if right A is of most value to someone who
also holds right B, they come in the same bundle. The right to decide
what happens two feet above a piece of land is of most value to the
person who also holds the right to use the land itself, so it is
sensible to include both of them in the bundle of rights we call
"ownership of land." But the right to decide who flies a mile above a
piece of land is of no special value to the owner of the land, hence
there is no good reason to include it in that bundle.

If, when general legal rules were being
established, we always knew what rights belonged together, the
argument of the previous paragraph would be sufficient to tell us how
property rights ought to be defined. But that is rarely the case.
Many rights are of substantial value to two or more parties; the
right to decide whether loud noises are made over a particular piece
of property, for example, is of value both to the owner of the
property and to his next-door neighbors. There is no general legal
rule that will always assign it to the right one.

In this case, the argument underlying the Coase
Theorem comes into play. If we assign the right
initially to the wrong person, the right person, the one to whom it
is of most value, can still buy it from him. So one of the
considerations in the initial definition of property rights is doing
it in such a way as to minimize the transaction costs associated with
fixing, via private contracts, any mistakes in the original
assignment.

An example may make this clearer. Suppose damages
from pollution are easy to measure and the number of people downwind
is large. In that case, the efficient rule is probably to give
downwind landowners a right to collect damages from the polluter but
not a right to forbid him from polluting. Giving the right to the
landowners avoids the public good problem that we would face if the
landowners (in the case where pollution is inefficient) had to raise
the money to pay the steel mill not to pollute. Giving them a right
to damages rather than giving each landowner the right to an
injunction forbidding the steel mill from polluting avoids the
holdout problem that the mill would face (in the case where pollution
is efficient) in buying permission from all of the
landowners.

A more complete explanation of how Coase's
argument can be applied to figuring out what the law ought to be
appears in the next chapter; a full explanation would require a
book—one that has not yet been written. I hope I have said
enough to make the basic idea clear. Coase started with a simple
insight, based in part on having read cases in the common law of
nuisance, the branch of law that deals with problems such as noisy
factories next door to recording studios. He ended by demonstrating
that what everyone else in the profession thought was the correct
analysis of the problem of externalities was wrong and, in the
process, opening up a whole new approach to the use of economics to
analyze law.

Coase's argument first saw print in "The Problem
of Social Cost," the most cited article in the economic analysis of
law and one of the most cited articles in economics. In addition to
showing what was wrong with the conventional analysis of
externalities, the article made a number of related
points.

Economists (and others) tend to jump from the
observation that the market sometimes produces an inefficient outcome
to the conclusion that, when it does, the government ought to
intervene to fix the problem. Part of what Coase showed was that
there may be no legal rule, no form of regulation, that will generate
a fully efficient solution, the solution that would be imposed by an
all powerful and all knowing dictator whose only objective was
economic efficiency. He thus anticipated public choice economists
such as James Buchanan (another Nobel winner) in arguing that the
choice was not between an inefficient solution generated by the
market and an efficient solution imposed by the government but rather
among a variety of inefficient alternatives, private and
governmental. In Coase's words, "All solutions have costs and there
is no reason to suppose that government regulation is called for
simply because the problem is not well handled by the market or the
firm." He further argued that the distinction between market
solutions and government solutions was itself in part artificial,
since any market solution depended on a particular set of legal rules
established by the legislature and the courts.

A second interesting feature of Coase's work was
mentioned in chapter 1. Coase got to his conclusions in part by
thinking about economic theory and in part by studying law. He based
his argument on real cases in the common law of nuisance—a
Florida case where one landowner's building shaded an adjacent
hotel's swimming pool, a British case where a physician built a new
consulting room at the edge of his property adjacent to a neighboring
candy factory and then demanded that the candy factory shut down
machinery whose vibrations were making it hard to use his consulting
room, and many others. He concluded that common law judges had
recognized and attempted to deal with the problem of joint causation
of externalities, a problem that the economic analysis of
externalities had entirely missed.